Understaing the Basics of Pricing

In business understanding pricing is a very important part and perhaps the most critical part of your business model. Below is another excerpt from the book Growing Happiness that provides an introduction into pricing. Much of what I know comes from the book the Strategy and Tactics of Pricing.

 
Capitalism also tends to focus on supply and demand curves and the idea that prices find a point that balances the supply and demand. This is important because part of capitalist theory falsely rests on the idea that market forces will dictate supply and demand, and the services offered. In other words, if something sells cheaply, more people will buy it, and if it is higher in price, fewer people buy it. Simultaneously, suppliers will be less interested in producing something less expensive and be more interested in something they can sell for a higher price and better profit. When these two impulses combine the price of something will reach an optimum point that balances the needs of the suppliers with the needs of consumers. This is what we traditionally call the market.

This sounds reasonable, but unfortunately this theory is not true. Consider the leading companies in quantity of sales, companies like Apple, Sony, Starbucks, Oracle, Verizon, and Microsoft. Then ask yourself for a moment if they have the lowest price. There are cheaper phones, MP3 players, database solutions, cell phones, and coffee.

The relationship between price and quantity sold simply does not exist. What is true, however, is the relationship between perceived value and price. The higher the difference between perceived value and price, the greater the sales will be. To this end, clever marketers spend a great deal of time emphasizing value.

To better understand this concept, we first have to understand some basic points about pricing theory. The goal of selling a product or service is to maximize profits. How much profit is a combination of the price and the quantity sold. When customers determine a fair price, they make the following mental calculations. We usually do this quickly and subconsciously.

1. What is the alternative?
2. How does this choice compare and constrast with the alternative?
3. Is the price justified based on this comparison?

For example, a thirteen-ounce tub of Vaseline costs about $4.50. A tiny 0.35 ounce tube of Vaseline Lip Therapy is about $1.99. In other words, Vaseline Lip Therapy is about sixteen times costlier than Vaseline in a jar, even though they are essentially the same product. Why don’t consumers protest? Why are sales of Vaseline Lip Therapy high? This is because the perceived competition to Vaseline in a jar is a store brand that costs about $3.99. The competition to Vaseline Lip Therapy is Chapstick, which is about $1.40. By packaging Vaseline more like a lip balm, they sell more and at a higher price for a much greater profit.

Even with commodities such as oil or gold, business people are quick to point to differences in price, and they will often note where the commodity comes from. For example, American versus foreign oil. Or Iranian gold versus Egyptian.

At retailers like Walmart, where price seems to sell, if you look closely at what is really attracting consumers, it is the perceived value. They sell products with a relatively high perceived value at lower prices. It’s not that the cheapest DVD player is selling best, but that a Panasonic DVD player costs less at Walmart than at many other retailers and that, in turn, draws consumers.

Suppliers are not motived by price to increase volume. They are motivated by profit—both financial and emotional. Suppliers that have other motives will not last long. This difference is key. Starbucks could sell coffee at cheaper prices, but they enjoy providing a quality experience in their stores. Starbucks employees are highly motivated because the company respects them. The chain has higher prices than many competitive stores, and they outsell everyone else.

Suppliers are interested in maximizing the difference between perceived value and price. There are many ways to increase the perceived value, including advertising and positioning. The perceived value of a product no one knows about is zero. One of the reasons companies like Apple and Oracle have done well is they have focused on communicating value to people who did not know that these products existed or did not think that these products had value for them. Competitors of these companies abounded, but most people were unaware of them.